Why we do Economic Modeling

Economic models are simplified descriptions of reality. Models can be used to yield insights into economic behaviour. These insights, in turn, can be used to develop hypotheses about future behaviours that can be tested. So, the power of models lie in their ability to generate insights and develop predictions about what may happen in the future.

Simple models – toy models, as I call them – can yield surprisingly powerful insights about economic behaviour. For example, even the simple line model developed by Harold Hotelling can yield surprisingly useful insights about firm behaviour under product differentiation.

How do we build models? Hal Varian, Google’s chief economist has written extensively on this (Paul Krugman is another), and we tend to follow the principles espoused by those two eminent thinkers. As Varian says, the first step is to identify the various pieces of the model. For example, in most models there are economic agents who interact in some way. These economic agents could be firms, consumers, etc. These agents have to make choice decisions in order to achieve their desired objectives. The choices of the economic agents are usually bounded or constrained within the model – for example, buyers may face budget constraints, firms may face capacity constraints, etc. The presence of constraints suggests that there must be something in a model that adjusts to ensure that the choices made by economic agents are mutually consistent.

When modeling, we always strive for simplicity or, more properly, to simplify complexity. It is a complex world out there, and a model should always strive to reduce complexity to something that is tractable. For example, simple one or two-period models, with two agents, two goods, and linear utility can often yield surprisingly powerful insights into consumer behaviour. Relaxing the assumptions on which the model may be built – for example, homogenous goods, constant prices, etc. – allows the modeler to more closely approximate reality, yielding further insights.

Economic models are powerful tools with which to try and make sense of complex market interactions and behaviours. Besides yielding useful insights, they often yield results that can challenge well-held assumptions and beliefs. As such, economic models are an integral part of our strategy and marketing practice at ALCG.

Building a Market Strategy: Some Key Questions

In many markets, consumers rarely view competing products as identical. Even if the features, characteristics and attributes of competing products are the same, branding may create perceived differentiation in the consumer’s mind. These thoughts suggest some key questions that firms should consider when thinking about product differentiation.

First there is the question of how consumers perceive products and services. This is another way of saying that it is really consumer preferences that determine differentiation. Heterogeneity among consumers, in terms of preferences, gives rise to differentiation – firms may choose to design products and services which serve particular bundles of consumer preferences. This implies that, in order to achieve differentiation which is valuable to customers, firms must study and understand consumer preferences.

Secondly, it is important to know the extent to which different consumers share the same preferences. Choosing to serve consumer preferences which are not widely shared may lock a firm into serving a small and static market niche. Thus, firms need to also study and understand the distribution of consumer preferences over the population of consumers who may buy the product or service being offered.

Thirdly, firms should try to understand the demand curves of the various consumers who may buy a product or service. Here, the issues of discrete choice (brand preference) and unit demand need to be considered. For example, in the car market, it is a reasonable assumption that consumers will buy a single car, but this population of consumers will have heterogeneous tastes and preferences. In other markets, however, these assumptions may not hold. For example, with beer or carbonated drinks, discrete choice is often a reasonable assumption to make, but consumers will differ in their individual demand curves.

Finally, firms should consider the extent to which consumers care for product variety. In some markets, consumers enjoy and welcome variety. For example, in the wine market, a large number of consumers actually enjoy product variety and they will buy variable quantities of product. In these cases, neither discrete choice nor unit demand are good assumptions to make.

Why are these questions important? Simply that the answers to these questions drive the assumptions that an analyst might make when attempting to model consumer behaviour and product differentiation. Overlooking these questions, or failing to address them, can result in models that are not good representations of reality. This, in turn, can result in misguided market and product strategies.

Further Thoughts on Differentiation

The objective of differentiation is to create a position in the marketplace which is unique. Rather than engaging in price competition, a firm pursuing a differentiation strategy aims to create a defensible competitive position based on non-price factors. In industries where there are many sellers and relatively homogenous products, differentiation is critical to avoiding price competition.

Before talking about differentiation, it is, of course, possible to compete through a cost advantage strategy. Achieving the lowest cost structure in an industry allows a firm to extract a higher margin or price lower than rivals. However, it is not easy to achieve an industry-leading cost structure, and such competitive positions can rarely be maintained as the sources of lower costs can often be copied by rivals. Lower input costs (i.e., raw material costs) are always preferable but are rarely the source of an enduring cost advantage. Unless the supply of these inputs is protected under some sort of exclusive arrangement, these lower input costs may be replicated by rivals. In addition, cost advantages are rarely created by lower input costs alone; rather, they are often created by exploiting economies of scale, economies of learning, standardized product design, or the ability to rapidly flex capacity in response to changes in market demand.

Secondly, differentiation is about creating meaningful differences, not better sameness. The degree to which a firm can successfully differentiate itself allows that firm to gain some market power and achieve a markup over cost. Where differentiation is weak, price competition will prevail and markups over marginal cost will be small. Where differentiation is strong, price premiums can be charged and markups over marginal cost will be correspondingly larger. A key point to note is that successful differentiation allows an optimal pricing strategy, which is a proportional markup over marginal cost that is independent of other firms’ pricing strategies. Thus, with good differentiation, prices can be maintained no matter what pricing strategy rivals adopt.

However, differentiation doesn’t just allow a firm to charge a higher markup and achieve a higher margin. Equally important, differentiation desensitizes the customer to competitive offerings. When a customer perceives that the value being offered is in some way distinct and superior, that customer becomes less willing to substitute a competitive offering, even if that offering has a lower price. Thus, differentiation can make a firm’s demand curve less elastic.

A final point to make: differentiation can be achieved without altering the product itself. While making physical changes to a product can be a source of differentiation, the same effect can sometimes be achieved by creating, in the customer’s mind, a different perception of the value being offered. This is especially important for “commodity” type products where it may not be possible to make physical changes to the offering. Thus, how the product is described and marketed to the customer may, in itself, be a source of differentiation.

Other sources of differentiation beyond the physical product can be brand (or image), service (sometimes bundled with the product), and personnel. It is interesting to note that quality is often misused as a differentiating factor. For many customers, what is important is quality parity among suppliers, where a certain level of quality is expected. However, these same customers may not necessarily be willing to pay for additional levels of quality.

It may even be that, in some cases, differentiation doesn’t even have to meaningful to succeed.  For example, Alberto Culver makes a shampoo called Natural Silk to which it does add silk, despite admitting in an interview that silk does nothing for hair. But offering and promoting this product attribute attracts attention, creates a distinction, and implies a better working formula which, in turn, attracts customers.